August 7, 2009

Economist's View - 6 new articles

School for Scoundrels, Book Review by Paul Krugman: Last October, Alan Greenspan — who had spent years assuring investors that all was well with the American financial system — declared himself to be in a state of "shocked disbelief." After all, the best and brightest had assured him our financial system was sound: "In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. . . . The whole intellectual edifice, however, collapsed in the summer of last year."

Justin Fox's "Myth of the Rational Market" brilliantly tells the story of how that edifice was built — and why so few were willing to acknowledge that it was a house built on sand. ...

Instead of focusing on the errors and abuses of the bankers, Fox ... tells the story of the professors who enabled those abuses under the banner of the financial theory known as the efficient-market hypothesis. ... Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy. ...

One of the great things about Fox's writing is that he brings to it a real understanding of the sociology of the academic world. Above all, he gets the way in which one's career, reputation, even sense of self-worth can end up being defined by a particular intellectual approach, so that supporters of the approach start to resemble fervent political activists — or members of a cult. In the case of finance theory, it happened especially fast...

In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process. ...

I came away ... wondering if [the] underlying premise — that the current crisis will put an end to Panglossian views of financial markets — is right. Fox points out that academic belief in the perfection of financial markets survived the 1987 stock market crash and the bursting of the Internet bubble. Why should the reaction to the latest catastrophe be any different? In fact, what I hear from my finance professor friends is that there's a lot less soul-searching under way than you might expect. And Wall Street's appetite for complex strategies that sound clever — and can be sold to credulous investors — survived L.T.C.M.'s debacle; why can't it survive this crisis, too?

Most everything that can be said about the jobs report has already been said, so here's a roundup of various reactions. The point I want to emphasize is that it's far too soon for policymakers to begin easing up, they need to plan as though this is just a temporary aberration in the numbers. If that turns out to be wrong, then the plans do not need to be executed, but it's essential that we are ready to react if needed (e.g., though I think the political climate makes any action highly unlikely, policymakers could enact expenditures that kick in if the numbers in future reports fail to meet predetermined thresholds so that if there is sufficient improvement in the economy, the money won't be spent):

A remarkable jobs report, by Free Exchange: ...[T]he new nonfarm payroll employment data released by the Labor department this morning ...[shows] July job losses of just ... just 247,000... Just as remarkable, the unemployment rate actually declined, from 9.5% to 9.4%. This may end up being a short-term aberration, but it is a very unexpected and positive one.

Manufacturing employment fell by 52,000 for the month, the first time in ages that the number has been below 100,000. Health industry and government employment moved upward. Meanwhile, hours and earnings both rose, in a very good sign for the job market.

The news isn't all good. Since the recession began a total of 6.7 million jobs have been shed, and nearly 15 million people are currently out of work. And the number of long-term unemployed (those out of work for 27 weeks ore more) has reached 5 million—a third of those currently out of work. It is those workers that will have the most difficulty finding new employment, which is what must happen for the unemployment rate to decline to "normal" levels.

But this is one of the best economic reports America has seen to date...

My feeling is that it's far too early to say that unemployment has stopped rising, and that clearly nobody believes employment has stopped falling. ...

All the same, on such a happy day it would be churlish not to take some joy from today's figures. The most vertiginous part of the economic plunge is clearly over, and there's some real hope for (modest and painful) economic recovery going forwards...

The Least-Bad Jobs Report in a Long Time, by David Leonhardt: The story of today's jobs report is pretty simple: given what was expected, it's very good news. ... The one thing that doesn't deserve much excitement is what will probably garner many of the headlines: the drop in the unemployment rate. It happened only because more people stopped looking for work and were thus ineligible to be counted as officially unemployed. The share of adults with jobs actually fell: to 59.4 percent, from 59.5 percent.

So the job market and the economy are still in bad shape. But, all in all, this was a very good report.

Nonfarm payroll employment continued to decline in July (-247,000), and the unemployment rate was little changed at 9.4 percent, the U.S. Bureau of Labor Statistics reported today. The average monthly job loss for May through July (-331,000) was about half the average decline for November through April (-645,000). In July, job losses continued in many of the major industry sectors.

Click on graph for larger image.

This graph shows the unemployment rate and the year over year change in employment vs. recessions.

Nonfarm payrolls decreased by 247,000 in July. The economy has lost almost 5.7 million jobs over the last year, and 6.66 million jobs during the 19 consecutive months of job losses.

The unemployment rate declined slightly to 9.4 percent.

Year over year employment is strongly negative.

The second graph shows the job losses from the start of the employment recession, in percentage terms (as opposed to the number of jobs lost).

For the current recession, employment peaked in December 2007, and this recession was a slow starter (in terms of job losses and declines in GDP).

However job losses have really picked up over the last year, and the current recession is now the 2nd worst recession since WWII in percentage terms (and the 1948 recession recovered very quickly) - and also in terms of the unemployment rate (only early '80s recession was worse).

With fewer job losses ("only" a rate of 3 million job losses per year), and the dip in unemployment rate, this will be consider an improvement. It is still a weak employment report. Much more to come ...

Most importantly, aggregate hours worked were unchanged at 91.1 as compared to 104.1, 101.7 and 99.7 over the last three quarters. An unchanged reading is a massive improvement from the 8% to 9% rate of decline over the past three quarters. With positive productivity this impies that thrird quarter real GDP growth could easily be positive..

Moreover, the manufacturing work week rose from 39.5 to 39.8 hours and overtime hours were 2.9 hours versus 2.8 in the second quarter. Much of this was auto and confirms the other reports that at least auto output is rebounding. The hours worked together with productivity strongly impies that manufacturing output rose in July -- to be reported about mid-month. Moreover, the average workweek and overtime hours are traditional leading indicators.Wage growth improved, but not enough to reverse the sharp slowing in average hourly earnings growth.

With hours worked stable and hourly earnings rising average private weekly earnings rose from $611.49 to 614.34.
The improvement in weekly earnings is a welcome sign... Tax cuts are offsetting some of this weakness but a sustained recovery requires growth in real income.

The consensus forecast is for a very weak recovery. But the consensus forecast is always for a weak recovery. The actual historic record is for recoveries to be proportional to the recession. That is, severe recessions have strong recoveries and mild recessions have weak recoveries.
I'm not making a forecast or taking a position that the consensus is wrong, or that those who expect no recovery are wrong either. But at every bottom economists always have a long list of reasons why this recovery will be weak. And they are usually wrong. In 1981, I won the National Association of Business Economists annual forecasting contest by forecasting an average or normal recovery from the 1980 recession. It was the strongest forecast in the competition.Footnote. Despite the increase in the minimum wage the teenage unemployment rate actually fell.

What's going on with broader measures of unemployment?:

Jobs paradox?, by Paul Krugman: ...[H]ow do we measure unemployment? ... It comes, instead, from a survey in which people are asked whether they're working and, if not, whether they're looking for work. And what this month's data show is a relatively large rise in the number of people "not in labor force" — neither working nor looking for work. That's how the unemployment rate can fall even with fewer people working.

Isn't U6, the broadest measure of unemployment, supposed to include people who are discouraged and stop looking? Yes — but at least according to the survey, that's not the reason more people have dropped out of the work force.

Basically, though, what you need to bear in mind is that these are imperfect measures, subject to a fair bit of noise. When the trend in the labor market is very strong in either direction, the measures move together. But when you have the kind of scene we have now — the employment situation is drifting down, but not plunging — occasional mixed signals are likely. No big deal.

The basic story is that things are sort of stabilizing — but they're definitely not improving yet.

So let's be grateful that the economy is getting worse more slowly than it was. But don't be lured into thinking we're ever going back to where we were. Most of the jobs that have been lost are never coming back. New ones will replace some of them, eventually, but hardly all of them. The structure of the American economy is changing. We will emerge from all this with an economy that looks strikingly different from the one we had in 2007. More on this to come.

Justin Fox also notes "bad news" in the report:

Jobs! Jobs! Jobs!, by Justin Fox: ...The bad news is that there are no real signs of economic life in the details of the employment report, just a slowdown in the pace of losses in most of the big categories. The most significant job creation was in health care, which added 19,600 jobs. But that's nothing new, and it's not unmitigated good news—we want to cut health care spending, don't we? The federal government added 12,000 jobs, "arts, entertainment, and recreation" added 10,000 (who knew?). Oh, and the auto industry supposedly added 28,000 jobs, but I'll let the BLS explain that away:

In motor vehicles and parts, fewer workers than usual were laid off in July for seasonal retooling. ... In large part, July's seasonally-adjusted increase reflects the fact that previous job cuts had been so extensive that there were fewer workers to lay off during the seasonal shutdown.

The above numbers are seasonally adjusted—which is necessary to do, but adds lots of potential for weird statistical quirks like the auto employment increase. Without the seasonal adjustments, employment fell a whopping 1.3 million in the month. And there were 5.9 million fewer jobs in July 2009 than in July 2008. ...

The CBPP takes a look at long-term unemployment, and the news isn't good:

CBPP Statement, by Chad Stone: Today's employment report shows that labor market conditions remain extremely harsh for job-seekers, generating a record level of long-term unemployment. One third of the unemployed (33.8 percent) have been looking for work for 27 weeks or more — the highest percentage ever recorded in data going back to 1948 and well above the peak reached in the severe 1981-82 recession (see Figure 1).

The report also shows that the deterioration in labor market conditions has slowed considerably from earlier this year, suggesting an economic recovery may be in sight. But that news must be tempered by the ongoing plight of the long-term unemployed....

Why did the unemployment rate fall?:

Why exactly did the unemployment rate fall?, by Rebeccas Wilder: Please correct me if I'm wrong. But the labor force is really big, 154,503,000 (see Table A on the BLS news release). Compared to that, the number of unemployed is really small, 14,462 (see the same table).
If the decline in number of unemployed, -267,000 was 63% the size of the decline in the labor force, -422, which shift is the dominant factor in the falling unemployment rate?

Nonfarm payroll employment continued to decline in July (-247,000), and the unemployment rate was little changed at 9.4 percent

But the unemployment rate was 9.5 percent in June. Had the Administration been Republican, Lawrence Kudlow would be hailing this report as good news. Paul Krugman offers a different tone:

Some readers have asked how it's possible for unemployment to fall when the economy is still losing jobs, albeit at a slower rate. The answer is a bit annoying. First, the jobs number and the unemployment number are based on different surveys — a survey of establishments in the first case, a survey of households in the second. Sometimes employment rises by one measure while falling by the other, although it happens that this month there isn't much difference in the jobs number.

The household survey also showed job losses – with its figure being 155,000, which drove the employment-population ratio down from 59.5% to 59.4%. The labor force participation rate, however, also fell from 65.7% to 65.5%. The employment picture got a little worse last month or as Paul concludes:

the employment situation is drifting down, but not plunging — occasional mixed signals are likely. No big deal. The basic story is that things are sort of stabilizing — but they're definitely not improving yet.

Finally, policymakers should look at the numbers the way Michael Mandel does and plan accordingly. It's far to soon for policymakers to ease up, and in fact, they ought to planning for more stimulus in case this is correct:

The Calm before the Storm?, by Michael Mandel: This morning's jobs report seemed to show a firming-up of the labor market, with the unemployment rate dropping a tad, from 9.5% to 9.4%. Job losses have slowed too, down only 247,000 in July.

But one month's numbers do not make a recovery. I'm betting that this may be just a temporary pause before the labor market worsens again towards the end of 2009. What happened is that the government has poured an incredible amount of money into the economy, through both monetary and fiscal stimulus. Policymakers have managed to blunt the downward spiral, which is a tremendous achievement. No depression on Bernanke's watch.

But consumers are still cutting back, and the personal savings rate still has more to rise. I would treat this as the eye of the hurricane, with more yet to come.

I agree that the analytical tools economists use are not the problem. We cannot fully understand how the economy works without employing models of some sort, and we cannot build coherent models without using analytic tools such as mathematics. Some of these tools are very complex, but there is nothing wrong with sophistication so long as sophistication itself does not become the main goal, and sophistication is not used as a barrier to entry into the theorist's club rather than an analytical device to understand the world.

But all the tools in the world are useless if we lack the imagination needed to build the right models. Models are built to answer specific questions. When a theorist builds a model, it is an attempt to highlight the features of the world the theorist believes are the most important for the question at hand. For example, a map is a model of the real world, and sometimes I want a road map to help me find my way to my destination, but other times I might need a map showing crop production, or a map showing underground pipes and electrical lines. It all depends on the question I want to answer. If we try to make one map that answers every possible question we could ever ask of maps, it would be so cluttered with detail it would be useless, so we necessarily abstract from real world detail in order to highlight the essential elements needed to answer the question we have posed. The same is true for macroeconomic models.

But we have to ask the right questions before we can build the right models.

The problem wasn't the tools that macroeconomists use, it was the questions that we asked. The major debates in macroeconomics had nothing to do with the possibility of bubbles causing a financial system meltdown. That's not to say that there weren't models here and there that touched upon these questions, but the main focus of macroeconomic research was elsewhere.

One major debate, for example, was the rate at which the macroeconomy returns to its long run equilibrium after a shock. Both New Keynesians and Chicago type equilibrium theorists believed the economy was always moving in the right direction—toward long-run equilibrium—the question was simply how fast that movement occurred and whether there was any role for policy to help the process along. Neither side of the debate seriously considered the possibility that the economy would continue to move away from its long-run equilibrium outcome for a substantial period of time—for years—as a housing price bubble developed, and that once the bubble popped the interconnectedness of financial markets would cause the problem to spread in a falling domino fashion that would throw the entire economy into a deep recession.

The interesting question to me, then, is why we failed to ask the right questions. For example, notice Mr Lucas' defence of the simulations that failed to predict the crisis:

[T]he simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period... Mr Mishkin's forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters.

I don't think we should be very impressed with the argument that once policymakers knew the economy was headed downward, the models were able to predict that the economy was headed downward. Further, even after it was known where the economy was headed, the models seriously underestimated the magnitude of the decline, and that led to an inadequate policy response.

But the important question is why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model? Why did we only get forecasts conditional on no crisis? And also, why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed?

It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession, the concentration of power over what research gets highlighted, the inadequacy of the tools we brought to the problem, the fact that nobody will ever be able to predict these types of events, or something else?

It wasn't the tools, and it wasn't lack of imagination. As Brad DeLong points out, the voices were there—he points to Michael Mussa for one—but those voices were not heard. Nobody listened even though some people did see it coming. So I am more inclined to cite the sociology within the profession or the concentration of power as the main factors that caused us to dismiss these voices.

And here I think that thought leaders such as Robert Lucas and others who openly ridiculed models they disagreed with have questions they should ask themselves (e.g. Mr Lucas saying"At research seminars, people don't take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another", or more recently "These are kind of schlock economics"). When someone as notable and respected as Robert Lucas makes fun of an entire line of inquiry, it influences whole generations of economists away from asking certain types of questions, some of which turned out to be important. Why was it necessary for the major leaders in macroeconomics to shut down alternative lines of inquiry through ridicule and other means rather than simply citing evidence in support of their positions? What were they afraid of? The goal is to find the truth, not win fame and fortune by dominating the debate.

We need to take a close look at how the sociology of our profession led to an outcome where people were made to feel embarrassed for even asking certain types of questions. People will always be passionate in defense of their life's work, so it's not the rhetoric itself that is of concern, the problem comes when factors such as ideology or control of journals and other outlets for the dissemination of research stand in the way of promising alternative lines of inquiry.

I don't know for sure the extent to which the ability of a small number of people in the field to control the academic discourse led to a concentration of power that stood in the way of alternative lines of investigation, or the extent to which the ideology that markets prices always tend to move toward their long-run equilibrium values caused us to ignore voices that foresaw the developing bubble and coming crisis. But something caused most of us to ask the wrong questions, and to dismiss the people who got it right, and I think one of our first orders of business is to understand how and why that happened.

There are other entries from (I'll update the list as more are added):

The Town Hall Mob, by Paul Krugman, Commentary, NY Times: There's a famous Norman Rockwell painting titled "Freedom of Speech," depicting an idealized American town meeting. The painting, part of a series illustrating F.D.R.'s "Four Freedoms," shows an ordinary citizen expressing an unpopular opinion. His neighbors obviously don't like what he's saying, but they're letting him speak his mind.

That's a far cry from what has been happening at recent town halls, where angry protesters — some of them, with no apparent sense of irony, shouting "This is America!" — have been drowning out, and in some cases threatening, members of Congress trying to talk about health reform. ...

[W]ell-heeled interest groups are helping to organize the town hall mobs. Key organizers include two Astroturf (fake grass-roots) organizations: FreedomWorks, run by the former House majority leader Dick Armey, and a new organization called Conservatives for Patients' Rights.

The latter group, by the way, is run by Rick Scott, the former head of Columbia/HCA, a for-profit hospital chain. Mr. Scott was forced out of that job amid a fraud investigation; the company eventually pleaded guilty to charges of overbilling state and federal health plans, paying $1.7 billion — yes, that's "billion" — in fines. You can't make this stuff up.

But while the organizers are as crass as they come, I haven't seen any evidence that the people disrupting those town halls are Florida-style rent-a-mobs. For the most part, the protesters appear to be genuinely angry. The question is, what are they angry about?

There was a telling incident at a town hall held by Representative Gene Green, D-Tex. An activist turned to his fellow attendees and asked if they "oppose any form of socialized or government-run health care." Nearly all did. Then Representative Green asked how many of those present were on Medicare. Almost half raised their hands.

Now, people who don't know that Medicare is a government program probably aren't reacting to what President Obama is actually proposing. They may believe some of the disinformation opponents of health care reform are spreading, like the claim that the Obama plan will lead to euthanasia for the elderly ... coming straight from House Republican leaders... But they're probably reacting less to what Mr. Obama is doing ... than to who he is.

That is, the driving force behind the town hall mobs is probably the same cultural and racial anxiety that's behind the "birther" movement, which denies Mr. Obama's citizenship. Senator Dick Durbin has suggested that the birthers and the health care protesters are one and the same; we don't know how many of the protesters are birthers, but it wouldn't be surprising if it's a substantial fraction.

And cynical political operators are exploiting that anxiety to further the economic interests of their backers.

Does this sound familiar? It should: it's a strategy that has played a central role in American politics ever since Richard Nixon realized that he could advance Republican fortunes by appealing to the racial fears of working-class whites.

Many people hoped that last year's election would mark the end of the "angry white voter" era in America. Indeed, voters who can be swayed by appeals to cultural and racial fear are a declining share of the electorate.

But right now Mr. Obama's backers seem to lack all conviction, perhaps because the prosaic reality of his administration isn't living up to their dreams of transformation. Meanwhile, the angry right is filled with a passionate intensity.

And if Mr. Obama can't recapture some of the passion of 2008, can't inspire his supporters to stand up and be heard, health care reform may well fail.

People are asking: Has Keynesian economics been proven wrong, now that it has been put to the test? The question, however, only makes sense if Keynesian economics had really been tried.

Indeed, what is needed now is another dose of fiscal stimulus. If that doesn't happen, we can look forward to an even longer period in which the economy operates below capacity, with high unemployment. ... The problem is that the shock to the economy from the financial crisis was so bad, even Barack Obama's seemingly huge fiscal stimulus has not been enough. ...

The Obama administration erred in asking for too small a stimulus, especially after making political compromises that caused the stimulus to be less effective than it could have been. It made another mistake in designing a bank bailout that gave too much money, with too few restrictions, on too favorable terms to those who caused the economic mess in the first place – a policy that has dampened taxpayers' appetite for more spending.

But that is politics. The economics is clear: The world needs all the advanced industrial countries to commit to another big round of real stimulus spending. ...

I agree that this is needed, and that time is of the essence, but I can't imagine the political climate allowing it to happen unless there is even worse economic news than we've already had, and even then it wouldn't be certain.